Active Investing Is Not Dead, By George! Patton Versus Passivism

Active investors have been uttering oaths a lot more colorful than “by George!” over the last few years. With flows moving from active to passive at unprecedented levels, it has certainly been a challenging time for active managers.

However, we remain as convinced as ever in the future of active management, and by Georges (Patton, Orwell, Carlin, and Soros), we are going to prove it!

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Active Investing Is Not Dead, By George! Patton Versus Passivism

Few American military commanders were as controversial as General George S. Patton. Born 1885, and with ancestors that fought in the Revolution, Mexican and Civil War, he decided from an early age he was destined for military greatness. He competed in the 1912 Stockholm Olympics in the first modern pentathlon (pistol shooting, fencing, 300 m freestyle swim, 800 m horseback and 4 km cross country run). He was the first member of the United States Tank Corps, and served until the corps was abolished in 1920, always believing tanks were the future of modern combat.

Patton was known for his bombastic leadership and flamboyant style, which included carrying pistols with ivory handles. A student of history, in part due to his belief in reincarnation, we invoke the memory of this iconoclastic general as we, too, look at history and take a controversial stance – that active management is not dead, and is destined for greatness over the coming years.

The Battle of the Bulge

Fund flows into passive have been enormous, forming a bulge not seen since the Allies rapidly advanced toward Germany in the winter of 1944.

“When it came to funds that focused on U.S. stocks, there was nearly a dollar-for-dollar switch: Passive funds brought in a record $236.7 billion in investor cash, while their active counterparts saw $263.8 billion go out the door, worse even than the $208.4 billion in outflows during the height of the financial crisis in 2008.” (Jeff Cox at cnbc.com; January 19, 2017)

The prolific proponents of passive investing, “passivists” as we propose calling them, are certainly having their moment. Wherever we look, we see headlines proclaiming the death of active management, and we recall Patton’s statement that: “If everybody is thinking alike, then somebody isn’t thinking”

In general, the “average” large cap manager, as defined by the passivists, underperforms over almost any time horizon, even five-years! Wow! Who knew that was the longest period one could evaluate in this age of big data. Never mind that we are in the eighth year of a bull market. Clearly that can’t influence the results of these studies. Although, we are reminded of Howard Mark’s admonition to “never confuse brains with a bull market.”

Maybe these passivists are really more end-point dependent in their analysis? Let’s take a look.

"Success is how you bounce on the bottom"

We decided to take a look at our bailiwick, small cap value, and see how our peers, as defined by Lipper using net of fees mutual fund data, have done since 1999. We can certainly see that recent results have not been kind to small cap value managers. Looking at rolling one-year periods, the only worse period was 2006, though it seems active managers bounced back strongly thereafter.

Rolling three year numbers look much the same, with a strong bounce back after 2006. Interestingly, on a rolling 10-year basis, more than half of managers currently beat the index net of fees, and have done so consistently.

Wait, that can’t be right, can it?

Orwellian Doublethink and the Passivist Orthodoxy

The chorus of voices condemning active management to the dustbin of history has been deafening lately, which reminds us of a quote from another famous George, Orwell in this case:

“Whoever is winning at the moment will always seem to be invincible.”

George Orwell (we know his given name was Eric Blair, but give us some latitude here) made this statement, and it certainly applies to the hubris with which passivists are thumping their chests, and the accompanying sense of resignation from many active managers (and their clients).

Orwell’s magnum opus, 1984, is currently soaring up the best seller list. If we think back to one of Big Brother’s favorite slogans, “Ignorance is strength”, we reveal the passivists view of the world. Essentially, it is better to claim ignorance of knowing how to select asset managers that will provide long-term outperformance and rely on the strength of the index creators and ETF providers to offer you strong returns through a rote process of index construction. The passivists are masters of Orwellian doublethink, simultaneously contending:

Markets are too efficient for active managers to outperform

Active managers only outperform in down markets

A classic paradox. Are markets less efficient when they are down, or does indexing work only by means of outsized flows into companies deemed part of the index by the party members at S&P, MSCI, or Russell? Best to simply adopt the passivist orthodoxy which, as Orwell stated, “Orthodoxy means not thinking--not needing to think. Orthodoxy is unconsciousness.”

What happens when we test the orthodoxy? A microcosm of what can happen when things turn against an ETF can be seen from what happens when the inflows stop, or (gasp) outflows occur for an ETF. Unsurprisingly, valuation becomes a matter of company fundamentals, not indiscriminate buying, and those companies not part of the ETF decline by far less. The following example, from FIG Partners, shows what happens when flows into ETFs focused on financials turn negative.

Between October 2016 and March 6, 2017, the dollars invested in an ETF that tracks the KRE Regional Bank Index rose 260% to $4.3 billion. The S&P Financials sector ETF, XLF, rose to $25.6 billion, more than tripling over this time. When both ETFs began to experience outflows in March, those banks not in an ETF declined 2.0%, while those held in ETFs fell 9.3%.

However, when times are good, as they have been for the last eight years, investing alongside the passivists is an easy way to win. Research from Jefferies shows that companies owned by small cap core managers that were in the Russell 2000 outperformed those outside the benchmark in every up quarter during 2016, accumulating an advantage of over 700 bps for the year! To use Orwellian newspeak, stocks held by managers not in the benchmark are ungood. What makes them ungood? Not being in the benchmark, where massive inflows and indiscriminate buying bid them higher.